Alternative reinsurance capital, in structures ranging from catastrophe bonds and insurance-linked securities (ILS), to sidecars and collateralized reinsurance structures, is increasingly embedded within the market, with re/insurers increasingly relying on it, according to rating agency Moody’s.
Speaking at a media briefing in London today, James Eck, Vice President and Senior Credit Officer at Moody’s Investors Service, said that ILS and alternative capital has become part of the fabric of the re/insurance market and is a key feature impacting its prospects.
“The flow of capital continues to be strong and now really firmly embedded in the sector,” Eck explained, adding that to the traditional insurance and reinsurance companies this “presents reinsurers with both a threat and an opportunity going forward.”
“Due to the cyclical and secular changes that are affecting the sector, we are beginning to see reinsurers take steps to adjust and adapt to this new reality,” Eck continued.
Reinsurance companies are adapting through mergers and acquisitions, or moving into new lines, or embracing ILS and alternative capital which is ultimately resulting in them becoming increasingly reliant on it, which can present its own risks.
“Are we seeing the emergence of a new reinsurance playbook between traditional reinsurers and alternative capital, or are the two still trying to find their relative strengths and weaknesses and trying to find a way to work together?” questioned Stanislas Rouyer, Associate Managing Director at Moody’s.
In some respects ILS or alternative capital and traditional reinsurance capital are beginning to look more alike each other, but differences remain in how they participate in the market, Rouyer continued.
“Is there an emerging new reinsurance market, where the two work to their strengths, or is it still evolving?” Rouyer continued.
These are questions that the rating agency asks of insurance and reinsurance companies it meets with, at events such as the upcoming Monte Carlo Rendezvous. Moody’s questions how reinsurers stay relevant in this market and what steps they take to achieve this.
Moody’s expectation is that reinsurance pricing will decline by single digit percentages at the next renewals in January and doesn’t foresee the pressure on pricing letting up. As a result the rating agency looks at what strategies the traditional market is taking and how they will affect profitability in the current cycle.
Moody’s opinion is that alternative capital could have changed the reinsurance cycle already, with an expectation that the changes may continue and potentially accelerate, as re/insurers continue to react and find ways to take advantage of new capital, develop new business models and increasingly consolidate.
In fact, while Moody’s feels that we may be near the bottom of the reinsurance cycle it does not believe that the upside will be the same in future.
On the subject of the cycle and reinsurers gaining the payback they typically seek post event, Rouyer said; “That issue has been complicated by the alternative capital, which may derail any price strengthening following a major catastrophe event.”
“Will the reinsurers be able to regain substantial profitability post-event, given the changing market?” Rouyer questioned again.
Moody’s is also seeing pricing pressure spreading into primary insurance lines of business.
“Even the alternative capital is getting there, that creates pressure on returns there too. It’s more attractive relatively, but we are seeing some of the signs of price competition in these lines,” Rouyer said regarding the prospects for those reinsurers that are looking to commercial lines of property insurance as a potential market that may hold more profitability.
Rouyer explained on pricing in reinsurance and the prospects for the January renewals that it may be helped by the fact that alternative capital appears to have reached the bottom of its risk appetite for key U.S. property catastrophe risks.
“The alternative market has kind of found its floor on the returns they are looking for on property cat at least,” he said. “That has contributed to a flattening of the deterioration in pricing. I don’t think we have a specific number in mind but it’s probably single-digit in range.”
Interest rates are also seen as a factor for reinsurance pricing now, as there is some thinking that if rates rise ILS investors may look elsewhere for returns.
Antonello Aquino, Associate Managing Director at Moody’s, explained; “If interest rates in the U.S. start picking up maybe part of this alternative capital will be more interested to move somewhere else, so that could decrease the pressure on pricing.”
In fact, Moody’s feels interest rates is such an important variable that it cites them as a factor that could result in it adjusting its negative outlook on reinsurers to a more stable view. However Aquino cautioned that it remains uncertain how the ILS market’s investors will react to a rate rise.
In fact there is some thinking that now ILS investors have become so embedded in reinsurance and have such a keen appreciation for the asset class, they are less likely to move elsewhere as they seek certain qualities within insurance and reinsurance as an asset class, rather than yield alone. Of course that remains to be seen.
As the embedding of alternative capital and ILS strategies or products has increased in reinsurance, the companies involved are becoming “progressively more dependent on it as a low cost source of retrocession,” Moody’s notes in its latest research.
The resource that alternative capital provides is undeniable, both insurers and reinsurers have perhaps never had access to so much high-quality risk transfer capacity at such attractive pricing. That provides opportunities as well as threats and challenges, meaning that it is the incumbents that are able to adapt best who stand the greatest chance of success going forwards.
Rouyer explained; ” People are still trying to figure out what will be the reinsurance market of the future. How do alternative and traditional reinsurance end up playing with each other? And that creates opportunities for people to try new things.”
This could result in even more capital coming into the sector, Rouyer said, but for the traditional reinsurance business model, if it becomes more important to be a strategic reinsurer for your partners, scale may end up being the key with billion dollar plus companies required on the traditional side.
While incumbents continue to look for the best way to adapt, alternative capital continues to deepen its embeddedness in re/insurance, expanding its remit through collateralized reinsurance and softening prices across an increasingly wide part of the market.
Moody’s sees casualty lines as an area under pressure from alternative capital, as well as mortgage insurance risks (citing the recent Bellemeade Re Ltd. (Series 2015-1) ILS transaction) and other areas that ILS has begun to touch on and it is “contributing to price erosion in other lines.”
The rating agency expects alternative capital will continue to grow, although at a slower rate, but it is likely to become increasingly embedded in re/insurance particularly while it remains largely untested by major loss events.
In years to come Moody’s expects that “Opportunities to deploy such capital are harder to find,” but as it becomes increasingly embedded re/insurers will need to adapt “both by competing with it and by aligning themselves with it.”
One of the key risks that Moody’s cites for re/insurers going forwards is becoming too closely dependent on alternative capital and ILS. The rating agency remains concerned that some investors could leave the sector after the next major event, and cautions re/insurers that a post-event capacity shortage could be a key risk to them.
But of course at present, while capital is abundant and cheaper than ever, re/insurers largely have better prospects by seeking to lower their own costs of capital through the use of capital from third-party investors. As a response to the soft market this should see uptake of ILS and alternative capital continue to grow for the time being, as opportunities allow.
The other risk Moody’s cited on alternative capital is investors desire to move into less well-modelled risks, in search of more attractive returns or diversification.
To date this has largely been controlled through experienced ILS managers with teams of underwriters, but Moody’s warns that there are likely investors who are overly reliant on models in the market right now. However the rating agency also said that there are reinsurers who are also overly reliant on risk models, so this risk is faced by traditional players as well.
Finally, on the subject of the future for the reinsurance cycle, pricing and whether traditional players will ever see the returns on equity and profitability that they have enjoyed in the past, Rouyer said.
“Will it get back to that level, or above that level, post-event? The question is how much dry powder does alternative capital have?”
While alternative capital and ILS is seen as an embedded piece of the market now, after that next big event the capital market may be ready to become even more deeply ingrained in the fabric of insurance and reinsurance capital.